Bonds Game Takes Savvy

LINDA STERN YOUR MONEY

If you think a bond mutual fund is a nice safe place to tuck away money while you wait for the stock market to settle, it may be wise to think it through a bit before writing that check.

There's a world of difference between individual bonds and the mutual funds that buy them. Investors who put money in bond funds thinking they are safe alternatives to stocks can learn that the hard way.

Bonds are really loans. When you buy a bond, you lend money to a company or government for a set amount of time. You earn interest, and at the end of that set amount of time, you get your loan back.

If you need to get repaid early, you can sell the bond before it matures. But then you run the risk that the bond has dropped in value and you'll have to sell it for less than its face value.

A mutual fund is a portfolio of bonds that never matures. They are always being traded before their maturity date, and bond fund investors always face the risk that they won't be able to get their money back when they sell shares.

"There is no way to know at what price you will be able to sell shares in a bond fund any time after you buy it," Annette Thau, a former bond analyst writes in the current issue of the American Association of Individual Investors Journal.

Those risks may even be elevated now, because bond prices move in opposition to interest rates. When rates fall, bond prices rise. Rates have been falling for several years -- that's why bond prices have been rising and bond funds have proven to be good investments since Alan Greenspan and the Federal Reserve started cutting rates.

But once the economy starts to show strength and rates turn higher again, bond prices will fall. That won't be much of a problem for investors who bought individual bonds.

Mutual fund fees can cut earnings on bonds currently paying pretty low rates of interest. The average intermediate-term bond fund charges 1.02 percent a year in fees, according to Morningstar. With seven-year bonds currently yielding less than 5 percent, that's a lot to pay.

Investors with at least $50,000 to put into bonds can avoid fund fees and problems by buying their own government bonds directly. They can divide their money into separate $10,000 increments, and buy different maturities, such as one, two, three, four and five years. Then, as their bonds mature, they can buy five-year bonds with each separate account.

Want to put some money in bonds but don't have at least $50,000?

A good bond fund can still provide diversification, as long as you don't count on having your money back on any set date. Thau suggests hunting for one with fees of less than 0.5 percent a year.

Linda Stern is a freelance writer who covers personal finance issues for Reuters. E-mail her at lindastern@aol.com.